Treasury Issues Proposed Regulations Related to Renewable Energy Tax Credit Monetization Elections

The U.S. Department of the Treasury (Treasury) earlier this week issued two notices of proposed rulemaking (the Proposed Regulations) related to the election to transfer certain tax credits (the Tax Credit Transfer Election) and the election for certain entities to be treated as making a payment against income tax equal to the amount of certain credits (the Direct Pay Election), each of which was added to the Internal Revenue Code as part of the Inflation Reduction Act of 2022 (the IRA).  In addition, Treasury issued temporary regulations related to pre-filing registration requirements for the Tax Credit Transfer Election and the Direct Pay Election.  The Proposed Regulations and the temporary regulations are scheduled to be published in the Federal Register on June 21, 2023.  Following is a high-level summary of some of the more significant aspects of the Proposed Regulations and the temporary regulations.

Tax Credit Transfer Election

General

The Tax Credit Transfer Election provides that an eligible taxpayer (i.e., a taxpayer other than a person that is eligible for the Direct Pay Election) (Eligible Taxpayer) may elect to transfer all or a portion of certain eligible tax credits (Eligible Credits) to an unrelated party.  Eligible Credits for this purpose include the alternative fuel refueling property credit, the production tax credit (PTC), the carbon oxide sequestration credit, the zero-emission nuclear power production credit, the clean hydrogen production credit, the advanced manufacturing production credit, the clean electricity production credit, the clean fuel production credit, the investment tax credit (ITC), the advanced energy project credit, and the clean electricity investment credit. 
Consideration for Eligible Credits must be paid in cash, but the amount of the payment is not required to be equal to the amount of tax credits transferred.  The Proposed Regulations confirm that if a transferee of the Eligible Credit pays less than the face amount of the tax credits transferred, the transferee does not have additional income as a result of the transfer or utilizing the transferred Eligible Credit. 

Tax Credit Transfer Election Mechanics

The Tax Credit Transfer Election is made by an Eligible Taxpayer with respect to the “specified credit portion” of each Eligible Credit that is transferred to the transferee taxpayer.  The specified credit portion is based on a proportionate share (which may be all) of an Eligible Credit determined with respect to each Eligible Credit property of an eligible taxpayer (Eligible Credit Property).  The Proposed Regulations make clear that in the case of the PTC, the Tax Credit Transfer Election may be made annually for each year of the 10-year credit period and must be made on a facility-by-facility basis.  Similarly, for the ITC, the election is made on an energy property-by-energy property basis.  The Proposed Regulations indicate, however, that if multiple energy properties are treated as a single "energy project," a Tax Credit Transfer Election may be made for the energy project as a whole. 

For an Eligible Taxpayer to make a Tax Credit Transfer Election with respect to an Eligible Credit, the Eligible Credit must be “determined with respect to” the Eligible Taxpayer.  The Proposed Regulations describe circumstances in which an Eligible Credit is not considered “determined with respect to the taxpayer” and, as a result, a taxpayer may not transfer such Eligible Credits.  This includes a circumstance in which an owner of ITC eligible property leases the property to a lessee, and the owner and the lessee make a “passthrough election” for the lessee to claim the ITC.  The proposed regulations provide that the ITC is not determined with respect to property of the lessee under these circumstances, and that the lessee may not transfer the ITC.

A Tax Credit Transfer Election that does not transfer the entire amount of Eligible Credit with respect to an Eligible Credit Property is considered a transfer of proportionate share of the entire Eligible Credit.  Thus, if an Eligible Credit Property qualifies for any bonus credit, for example because the property is placed in service in an energy community, discussed in our prior alert here, or satisfies the domestic content requirements, discussed in our prior alert here, and only a portion of the Eligible Credit is transferred, the transferred portion consists of a portion of the aggregate credit and a proportionate share of each bonus credit amount.  Thus, a taxpayer cannot designate that a transfer relates only to the “bonus credit amount.” 

A Tax Credit Transfer Election is made on an Eligible Taxpayer’s tax return and must be made on an original return not later than the due date for such return.  The election must include a statement describing the transfer, including identifying the Eligible Taxpayer and transferee and their respective taxable years, a description of the Eligible Credit, the total amount of the Eligible Credit, and the cash consideration paid.  In addition, the election must include a statement from the Eligible Taxpayer that the Eligible Taxpayer has provided certain “required minimum documentation” to the transferee.  The required minimum documentation includes information that validates the existence of the Eligible Credit Property, documentation substantiating qualification for any bonus credit amounts, and evidence of qualifying costs, in the case of an Eligible Credit that is an investment-based credit, or qualifying production activities, in the case of an Eligible Credit that is a production-based credit.

Pass-Through Entity Transferors and Transferees

If a partnership or S corporation (a pass-through entity) is the direct owner of Eligible Credit Property, any Tax Credit Transfer Election with respect to such Eligible Credit Property must be made by the pass-through entity.  A partner or S corporation shareholder is not allowed to make the election for its allocable share of Eligible Credits from the pass-through entity.  The income realized by the pass-through entity from the transfer is treated as tax-exempt income for applicable tax accounting purposes and allocated among partners (in the case of a partnership) in accordance with the applicable partnership agreement or among shareholders (in the case of an S corporation) pro rata.  The preamble to the Proposed Regulations make clear, however, that the cash received by the pass-through entity may be used in any manner by the pass-through entity, including for distributions, and that in the case of a partnership distributions of proceeds are not required to made on the same basis as allocations of tax-exempt income.

Under certain circumstances, the Proposed Regulations allow a partnership to make a Tax Credit Transfer Election that relates to only a particular partner’s allocable share of Eligible Credits.  If a partnership makes such an election, special partnership allocation rules may apply for purposes of allocating the tax-exempt income resulting from the transfer.

Both partnerships and S corporations may purchase Eligible Credits pursuant to a Tax Credit Transfer Election.  One example in the Proposed Regulations describes a partnership that is formed “for the purpose of purchasing” Eligible Credits.  Generally, if a partnership acquires Eligible Credits, the purchased credits are allocated to partners based on each partner’s distributive share of nondeductible expenses, as determined under the applicable partnership agreement.  If an S corporation acquires tax credits, the credits are generally taken into account by shareholders pro rata. 

At-Risk and Passive Activity Loss Rule Applicability

The Proposed Regulations provide that an Eligible Taxpayer transferor that is a pass-through entity generally is required to take into account the “at-risk” rules in determining the amount of Eligible Credit that may be transferred.  The pass-through entity must take into account any at-risk limitation applicable to its owners’ tax credit base as a result of certain nonqualified nonrecourse financing.  Information related to each partner’s or shareholder’s at-risk limitation must be included with the pass-through entity’s tax return that includes the Tax Credit Transfer Election.

The Proposed Regulations provide that the passive activity loss rules apply to the transferee of an Eligible Credit.  Generally, the passive activity loss rules apply to individuals, estates, trusts, closely held C corporations, and personal service corporations.  If a transferee is subject to the passive activity loss rules, the Proposed Regulations provide that the transferee is not considered to own an interest in the transferor Eligible Taxpayer’s trade or business and cannot change the characterization of the transferee’s participation in the Eligible Taxpayer, for example by applying certain activity grouping rules under the passive activity loss rules.  The preamble to the Proposed Regulations clarifies that, as a result of these rules, a transferee that is subject to the passive activity loss rules will be considered to earn any transferred credit through the conduct of a trade or business in which the transferee does not materially participate.  Thus, the transferee would be required to treat the transferred credits as passive activity credits to the extent the transferred credits exceed passive tax liability.

Investment Credit Recapture

The Proposed Regulations provide that, in general, if there is recapture of a transferred Eligible Credit, the transferee is required to pay any recapture amounts.  The Eligible Taxpayer is required to provide notice to the transferee of the recapture event, and the transferee is required to provide notice to the Eligible Taxpayer of the amount of any recapture.  The Proposed Regulations require that such notices be exchanged with sufficient time before the due date for both taxpayers’ returns (without extension) to allow the transferee to calculate the recapture amount and allow the Eligible Taxpayer to calculate any increase in tax basis resulting from the recapture. 

Recapture does not apply to the transferee, and no notices are required, in the case of certain recapture events related to an Eligible Taxpayer transferor that is a partnership or S corporation.  For general income tax purposes, investment credit recapture may apply to a partner in a partnership or a shareholder in an S corporation if the partnership or S corporation places in service investment property and, during the recapture period, the partner's interest in the partnership or shareholder's interest in the S corporation is reduced below a certain threshold (generally 66.66%).  Likewise, changes to “at-risk” amounts during the recapture period can result in partner- or shareholder-level recapture.  The Proposed Regulations provide that in the case of these types of recapture, in which the investment credit property continues to be investment credit property with respect to the transferor partnership or S corporation, a transferee of Eligible Credits will not be required to pay the recaptured amounts.  Instead, the relevant partner or S corporation shareholder, as applicable, would be subject to the recapture.  It is not clear exactly how this recapture will apply at the partner or shareholder level, and the preamble to the Proposed Regulations requests comments on this issue.

Excessive Credit Transfer

Generally, if a transferee of Eligible Credits claims more tax credits than would otherwise be allowable to the Eligible Taxpayer with respect to the relevant Eligible Credit Property, the transferee is subject to tax equal to such excess amount claimed, plus 20% of the excess amount.  Under the Proposed Regulations, if an Eligible Taxpayer transferred a portion of Eligible Credits to multiple transferees, the multiple transferees would be treated as a one transferee for purposes of calculating any excessive credit transfer amount.  Any tax and penalty as a result of such excessive credit transfer is calculated for each transferee based on the Eligible Credits transferred to such transferee relative to the Eligible Credits transferred to all transferees.  The preamble to the Proposed Regulations acknowledges that an agreement between the Eligible Taxpayer and transferee may address issues related to recapture and excessive credit transfer.

A transferee may avoid the 20% penalty if the transferee can show reasonable cause for an excessive credit transfer.  Whether a transferee had reasonable cause depends on the facts and circumstances, but the Proposed Regulations indicate that circumstances that may be considered include review of the Eligible Taxpayer's records, reasonable reliance on third party expert reports, reasonable reliance on representations from the Eligible Taxpayer, and reviews of financial statements and underlying information. 

Direct Pay Election

General

The Direct Pay Election provides a person (Applicable Entity) may make an election to be treated as making a payment against tax equal to certain applicable tax credits (Applicable Credits) for which such Applicable Entity qualifies.  The deemed payment is refundable to the extent it exceeds the electing Applicable Entity’s tax liability for the applicable year.  An Applicable Entity includes any organization exempt from federal income tax, any state or political subdivision thereof, the Tennessee Valley Authority, an Indian tribal government, any Alaska Native Corporation, or certain electric cooperatives furnishing energy to persons in rural areas.  The Proposed Regulations also define Applicable Entity to include any agency or instrumentality of any state, the District of Columbia, Indian tribal government, U.S. territory, or political subdivision thereof.  Applicable Credits for purposes of the Direct Pay Election include all Eligible Credits for the for the Tax Credit Transfer Election, as well as, with respect to certain tax-exempt entities, the qualified commercial vehicle credit. 

Electing Taxpayers

A taxpayer other than an Applicable Entity (Electing Taxpayer) may make the Direct Pay Election with respect to the clean hydrogen production credit, the carbon oxide sequestration credit, and the advanced manufacturing production credit.  An Direct Pay Election by an Electing Taxpayer generally applies for the taxable year of the election and the subsequent four taxable years.  The Proposed Regulations clarify that an Electing Taxpayer makes an election with respect to each facility with respect to which an Applicable Credit is determined, and may make the election with respect to each facility only once.  Thus, the maximum period an Electing Taxpayer may qualify for the Direct Pay Election with respect to any facility is limited to five years.

Limitations on Direct Pay Election

The Proposed Regulations provide clarification regarding certain limitations on the Direct Pay Election.  One significant limitation on the Direct Pay Election is that the election may be made only with respect to credits which have been determined with respect to an Applicable Entity or Electing Taxpayer.  The Proposed Regulations provide that this means an Applicable Entity or Electing Taxpayer could not purchase an Applicable Credit pursuant to a Tax Credit Transfer Election and then make an Direct Pay Election with respect to that purchased credit.  The Proposed Regulations also provide that an Applicable Credit that may be claimed by a lessee Applicable Entity or Electing Taxpayer pursuant to a lease-passthrough election is not eligible for the Direct Pay Election.  This prohibits an Electing Taxpayer from purchasing Eligible Tax Credits and then making a Direct Pay Election with respect those Eligible Tax Credits.

Limitation on Investment-Related Credits

The Proposed Regulations provide that if an Applicable Entity has income that is exempt from federal income tax that is used to purchase, construct, reconstruct or acquire property that is eligible for investment-based credits, including, for example, the ITC, such amounts are included in the basis of the property for the purpose of the Direct Pay Election.  If, however, an Applicable Entity receives a grant, forgivable loan, or other income exempt from federal income tax that is specifically for the purpose of purchasing, construction, reconstructing, or acquiring investment-related credit property, the amount of the Applicable Credit will be reduced so that the credit determined with respect to such property, plus the earmarked tax-exempt income, do not exceed the total cost of the property.  If, for example, investment-related credit property is purchased solely with tax-exempt income that was specifically provided for the purpose of purchasing the investment-related credit property, the Applicable Credit would be reduced to zero.

Pre-filing Registration Requirement

In addition to the Proposed Regulations, Treasury issued temporary regulations related to a mandatory pre-filing registration process related to each of the Tax Credit Transfer Election and the Direct Pay Election (the Pre-Filing Registration Requirements).  Under the Pre-Filing Registration Requirements, a person that intends to make an election under either the Tax Credit Transfer Election or the Direct Pay Election is required to register itself as intending to make such election and must, among other requirements, list all credits for which the person intends to make an election, and list each relevant credit property for which such election would be made.  The pre-filing registration process will be completed electronically through an Internal Revenue Service (IRS) electronic portal.  FAQs posted by the IRS related to the Tax Credit Transfer Election and the Direct Pay Election indicate that the electronic pre-filing registration process will become available later this year.

The person that intends to make either a Tax Credit Transfer Election or Direct Pay Election will receive a registration number for itself and for each credit property with respect to which an election will be made.  These registration numbers will be required to be included on the applicable election forms.  Neither the Tax Credit Transfer Election nor the Direct Pay Election may be made without applicable registration numbers.

Impact of Proposed Regulations

The Proposed Regulations clarify a number of issues that have arisen in transactions.  Some of these issues were addressed in a taxpayer-favorable manner and others were not.  Some of the most notable issues include:

• Eligible Credits that are purchased by an individual or entity that is subject to the passive loss rules are treated as passive activity credits that can only offset income from passive activities.This will significantly limit the number of taxpayers that can benefit from purchases of Eligible Credits.

• Partner-level recapture of a transferred ITC only applies to the partner whose interest is transferred, and does not apply to the transferee of the ITC.  This alleviates a significant concern regarding the use of back-leverage borrowing to construct ITC-eligible property.

• The lessee in a lease passthrough election transaction is not permitted to make a Tax Credit Transfer Election with respect to the ITC.  This may create a significant challenge for certain tax equity finance transactions that have been structured based on an assumption that the lessee could make a Tax Credit Transfer Election with respect to the passed-through ITC.

The Proposed Regulations are very detailed and likely will impact tax credit transfer transactions in many other meaningful ways. The Treasury Department has requested comments and will likely issue final regulations once those comments are received and discussed.  In the meantime, however, taxpayers may rely on the Proposed Regulations for transactions entered into before regulations are finalized.